5 Sources of Capital Debt (Selling New Bonds)Selling New Preferred StockCommon Equity: Retaining Earnings and/or Selling New Common StockEach of these offers a rate of return to investors, so all equity has a cost.A firm’s overall cost of capital is an average of the costs of the various types of funds the firm uses.

6 The Weighted Average Cost of CapitalWACC = wdrd(1-T) + wprp + wsrsThe w’s refer to the firm’s capital structure weights.The r’s refer to the cost of each component.A business will usually use several sources of long-term financing, not only one source.The optimal proportions of financing that should be raised from each source is called the optimal capital structure.For example, a business might have an optimal capital structure that consists of 30 percent debt, 10 percent preferred stock, and 60 percent common equity.

7 Cost of Debt Cost of raising funds by selling bonds.The effective rate that a company pays on its current bond. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often.

9 Cost of DebtTo get the after-tax cost of debt, we simply multiply the before-tax rate by one minus the marginal tax rate.Interest is tax deductible, so the after tax (AT) cost of debt is:rd AT = rd BT(1 - T)rd AT = 10%( ) = 6%.

10 Cost of Preferred StockFinding the cost of preferred stock is similar to finding the rate of return, except that we have to consider the flotation costs associated with issuing preferred stock.Flotation Costs is the costs of issuing a new security, including the money investment bankers earn from the spread between their cost and the price offered to the public, and the accounting, legal, printing and other costs associated with the issue.

12 Cost of Preferred StockIf Prescott Corporation issues preferred stock, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred stock for Prescott?8.0074.00== %

14 What are the two ways that companies can raise common equity?Directly, by issuing new shares of common stock.Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).

21 Retention Growth ModelMost firms pay out some of their net income as dividends and reinvest the rest.g = (ROE) (Retention rate) g = (ROE) (1 - payout ratio)The payout ratio is the percent of net income paid as dividend, defined as total dividends divided by NI.ROE is the return on equity, defined as NI available to common stockholders divided by common equity.

24 What’s a reasonable final estimate of rs?MethodEstimateCAPM14.2%DCF13.8%rd + RP14.0%Average

25 Determining the Weights for the WACCThe weights are the percentages of the firm that will be financed by each component.If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

26 Calculating the WACCThe weighted average cost of capital is just the weighted average cost of all of the financing sources.WACC = wdrd(1-T) + wpsrps + wcersThe w’s refer to the firm’s capital structure weights.The r’s refer to the cost of each component.

27 Estimating Weights for the Capital StructureIf you don’t know the targets, it is better to estimate the weights using current market values than current book values.If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.(More…)

28 Determining the Weights for the WACCEach firm has an optimal capital structure defined as the mix of debt, preferred, and common equity that causes its stock price to be maximized.Therefore, a value-maximizing firm will establish an optimal capital structure and then raise new capital in a manner that will keep the actual capital structure on optimal over time.The weights are the percentages of the firm that will be financed by each component.

33 In order to satisfy its investors, a business must invest in projects that earn at least the WACC.When investments are made in projects that earn more than the WACC, common stockholders wealth is increased.

35 Costs of Issuing New Common StockWhen a company issues new common stock they also have to pay flotation costs to the underwriter.Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

37 Adjusting the Cost of Stock for Flotation CostsWhen a company issues new common stock they also have to pay flotation costs to the underwriter.P0=$50, D0=$4.19, g=5%, and F=15%.re =D0(1 + g)P0(1 - F)+ g=$4.19(1.05)$50(1 – 0.15)+ 5.0%$4.40$42.50+ 5.0% = 15.4%